What are Capital Protection Funds

 Capital protection funds have made their way into India and soon domestic investors will witness quite a few of these schemes hitting the market. Investors may be wondering how this concept operates and how these funds can provide a risk-free scenario for their capital. However, investors should realise that they can construct the same structure as that of the capital guarantee fund in a manner that is suitable for them. Here is how this can be done.

Capital guarantee

First, investors should understand what the term capital guarantee implies. Capital guarantee means the capital sum invested by an investor is intact at the end of a specific time period. For example, if a person invests Rs 20,000 in a capital guaranteed scheme, then at the end of a certain time period, say five years, he will get back a sum of at least Rs 20,000. There can be a higher payout depending on the earnings of the scheme, but this will be additional earnings. So, an investor can be sure that he will not lose his capital. Hence, there is a guarantee of protection of capital, but no guarantee of return.

How to evaluate

While evaluating such offerings, investors should not concentrate on the capital returns, but should consider the amount they earn. This is because there are additional options present in the market. Using these routes, they can earn a specified sum by investing in a fixed deposit (FD) where the capital is safe, and at the same time there is also a fixed earning. The earnings have to be higher to justify the investment, or else the investor will be better off by putting his funds in an FD and earning returns.

Final calculation

The investors should first consider the time period for which they want a capital guarantee. This can be around three year.
The other option is to consider a slightly longer time period of five or seven years. Let us consider the example of a three-year period. Consider the earnings on the various FDs available for a three-year period. Suppose the rate is 7%. Now, you need to figure out the sum of money that invested today at the above mentioned rate will yield Rs 10,000 over the time period under consideration.

The same objective can be achieved by doing a backward calculation from Rs 10,000. The whole idea is to figure out the amount of investment that is needed today to have a cash in hand of Rs 10,000 three years down the line. One also needs to consider whether this is a simple return or whether there is some compounding at the end of the period; this can change the amount required for investment.

Suppose an individual has an amount of Rs 10,000 and he wants to ensure that at the end of three years, he has a minimum capital guarantee. In such a situation, the amount that needs to be invested, which will provide a sum of Rs 10,000 at the given earnings rate on a simple interest basis, is around Rs 8,264. The remaining Rs 1,736 can be invested in equities. Depending upon the earnings generated, the total earnings for the investor can be determined.

Assume that at the end of three years, the equity invested is completely wiped out, which is an unlikely scenario unless one invests in low-rung scrips that stop trading on the exchange. Even if this happens, the individual will get his capital back. Any additional sum earned implies that the earnings of the investor continue to increase.

The key lies in selecting the correct rate of return for the debt instrument so that there is complete safety as far as the basic investment is concerned. After that, the investor only has to try and generate some earning from the equity part to ensure that the total returns are boosted.

The higher the rate and the time period, the lesser is the amount that is required to be invested in the debt part. As a result, the additional amount goes to the equity part, which has a better chance of generating higher earnings. While ensuring capital guarantee, one has to be aware of the tax impact. The earnings from the debt part will be taxed as normal income without any deduction.

Get more information